When the senior treasury managers at Barclays plc, in that now-infamous passage from 2005 to 2009, directed the bank's LIBOR submitters to massage the rates they supplied to the British Bankers' Association downward, they invoked the perils of Barclays' "sticking its head above the parapet." LIBOR submitters would couch their compliance in jokey obsequiousness, calling their superiors "big boys" and "sir"; they were rewarded with the epithet of "superstars." Paul Tucker, the deputy governor of the Bank of England, in his testimony before Parliament, labeled the culture of manipulation that flourished at Barclays a "cesspit."
Parapets and cesspits, big boys and superstars: The road to this point in the LIBOR scandal has covered uncommonly varied geographical and human terrain. But where once there was diversity, now there is the repetitive drumbeat of outraged consensus: Everyone agrees that LIBOR needs to change. But how will it change, and what will happen to the cost of capital once it does?
"The idea that my word is my LIBOR is dead," Mervyn King, the governor of the Bank of England, has said, meaning that markets should no longer accept a system whereby LIBOR is based purely on the say-so of the handful of banks, most of them top-tier global houses, that submit the rates, and that actual transaction prices should be used as the basis for calculating the benchmark instead. The BBA has commissioned a review of the process for setting LIBOR; a spokesperson declines to comment on how far advanced that review is. But most analysts agree that basing LIBOR on actual transaction costs is the key to improving transparency, and that the political pressure on the BBA is so great that it will be compelled to do so.
"The cost of capital will inevitably increase once that happens and those conflicts of interest are removed," says Chris Huddleston, head of the money market desk at Investec Bank plc. The argument seems logical: Barclays, and potentially other banks, submitted rates below the level at which it could actually borrow in the interbank market; once the system is cleaned up, LIBOR-along with the myriad borrowing rates that are benchmarked to it -- should increase.
But things may not be that straightforward. LIBOR is calculated in multiple different maturities, from overnight to 12 months. However, not all of the banks on the BBA panel are active in all of those maturities. As things stand, those that do not borrow in certain parts of the LIBOR curve base their daily submissions on what essentially amounts to a guess. Tying inactive banks to submissions based on "real" rates would mean forcing them to submit a meaningless null value, or excluding them from the process altogether.
"If LIBOR were to be based just on actual transactions, rates could be lower than they are today," says Brian Smedley, director of rates research at Bank of America Merrill Lynch. "This is because in the longer tenors it's mainly the top-tier banks that would be able to contribute meaningfully to the process -- many of the other panel banks aren't actively borrowing beyond one month." Analysts have observed that in the three-month maturity, for instance, half of the LIBOR panel banks are not especially active. Were those banks to be excluded from the BBA's calculation process, three-month LIBOR would be around 10 basis points lower than it is today.
One other option for reform might see an increase in the number of panel banks. The more banks that contribute to the benchmark, the argument goes, the more accurate and representative it will be. But with democracy will come unpredictability. "You would see more dispersion in the panel" of submitting banks, says Smedley. "The cost of capital could become more unpredictable, and you could see more volatility in the fixings."
Whether the BBA moves in the direction of a larger panel, and whether banks would want to be associated with a now-tainted process, remain open questions. But were the panel to be expanded, the new banks would need to be active in the money markets and meet the BBA's other panel selection criteria. The 10 or so banks that could presently contribute most meaningfully to the process are mainly based in Scandinavia, Canada and Australia and include Australia and New Zealand Banking Group Ltd., Bank of Nova Scotia and Nordea Bank AB. Those banks have smaller balance sheets than the big global players already on the LIBOR panel, but that does not mean they borrow at higher rates; indeed, their inclusion on the panel could also see rates dip. "Many of them fund at lower levels than the biggest global banks," says Smedley, "so the fixings in certain tenors could actually end up being lower than they are currently."
LIBOR, it seems, is here to stay. But the cleaner, nicer new LIBOR won't necessarily mean that the cost of money will suddenly shoot up. A new funding landscape will likely emerge, but one potentially characterized by less consensus among the submitting banks and more unpredictability in interest rates tied to LIBOR. The view from the parapet is about to get a lot more interesting.